Foreign Exchange (FX) is the exchange of one country’s currency with another using a pre-defined rate of exchange. This means that you are giving away one currency and replacing it with another.
So, why should you get into an FX trade?
There are four key reasons: Speculation, Hedging, Arbitrage and Need-based. Majority of the participants (Investment Banks, Custodians, Market Makers etc) in the market trade FX with the aim of Speculation, Hedging and Arbitrage. The rest of the FX trade is need-based.
Let’s analyze each one.
- Need-Based: This primarily refers to entering into the FX market because you actually need the money. For example, you are travelling to Japan and hence require Japanese Yen (JPY) to spend locally. You will, therefore, convert Indian Rupees (Rs) to JPY, which means that you need JPY and therefore you have used FX. This is need-based trading—which, however, contributes very little to the overall volumes of FX traded globally.
- Speculate: This means that you take a position (long/short) into the market and then expect the exchange rates to move in your favor. This is very similar to buying shares in the market and expecting the price to go up so that you can sell and accordingly make a profit. As retail investors and as a starting point, you can invest in FX Futures (traded in National Stock Exchange & Bombay Stock Exchange, which are known as order-driven markets) and then divulge into over-the-counter (OTC) markets (Currenex, FXall etc) once you get a good understanding of FX trading.
- Hedging: This refers to protecting the risk of your investment by using FX. Let’s say, for example, that you are going to receive $ dividends from an investment four months later. The current exchange rate of $/Rs is 58.80. It is appropriate to say that if the Rs appreciates (which everyone is expecting due to the ‘positive outcome’ of the recently concluded elections), you will expect to get lesser Rs, and vice-versa. No one will like lesser returns on their investment, and therefore you can hedge from further Rs appreciation by entering into a FX forward transaction (with the settlement four months later) to convert $ into Rs, at let’s say 58.50. That way, you will be insulated against any further appreciation of the Rs vs. $.
- Arbitrage: This refers to the price differential of the same underlyer against two different markets. Since FX is an OTC product, you will always have the opportunity to buy/sell the same underlyer across two different markets, which could have two different prices. For example,. if you see the exchange rate of £ vs. $ as 1.6800 in the US OTC market and 1.6810 in the UK OTC markets, you can immediately place two orders – a) Buy £ vs. $ in the US market and b) Sell £ vs. $ in the UK markets—thereby, making a profit of $0.0010 per £. However, with the onslaught of algo/e-trading businesses of Investment Banks, arbitrage opportunities disappear within few seconds.
So, what is the common theme you have noticed in all four types of FX trades mentioned above? It is important to note that FX is a low-margin-high-volume/value business, which means you will have to invest a lot of money to make profits. So go ahead–Speculate, Hedge, use Arbitrage opportunities, or get into FX simply because you need the local currency. However, there is no denying one fact: All of us will get into the FX market at some point in our lives! If you find the FX world a tad complicated, education is the key. Learn more about foreign exchange trades in our comprehensive financial course called CIBOP (Certified Investment Banking Operations Professional).